What is the International Monetary System?
Many people work and travel outside of the U.S. where the dollar isn’t used as a currency. You may have heard of the international monetary system, but what exactly is it and why should you care? How about currency regimes? Why is it important to understand currency exchange rates? This article will provide a succinct overview of the history and importance of the international monetary system. Next, currency regimes will be reviewed along with delineating fixed/flexible exchange rates. Finally, the creation of the Euro will be discussed along with its benefits and problems associated with this ubiquitous currency.
Historically, governments based their exchange rates on the gold standard during the first attempt at globalization. With the gold standard, governments exchanged national currency notes for gold at a permanently fixed rate exchange rate. On July 1, 1944, delegates from 44 nations came together in Bretton Woods, New Hampshire, to work out arrangements for a new international monetary and financial order. This meeting occurred just after “D-Day,” where more than 160,000 Allied troops had landed on the beaches of Normandy to battle against the Nazi forces.
Bretton Woods represented the first time that governments explicitly and systematically made exchange rates a matter of international cooperation and regulation. American and British policymakers, Harry Dexter White and John M. Keynes, were the architects of the Bretton Woods agreement. The Bretton Woods agreement engendered two international institutions: the International Monetary Fund (IMF) and the World Bank, and their function was designed to replace private finance as more reliable source of lending in developing nations.
International Monetary System
The purpose of the international monetary system (IMS) is to facilitate international economic exchange since most countries have national currencies that are not typically accepted as legal payment beyond their borders. When the IMS is operating mellifluously, international trade/investment can flourish; however, when the IMS operates inefficiently or even completely fails (as in the Great Depression or the recent Credit Crisis), international trade/investment is throttled.
The essential element of the IMS is to facilitate the exchange of goods, services, and capital among countries. The IMS seeks to contribute to stable and high global growth while currently fostering price and financial stability. The IMS regulates the balance of payments, which is an accounting device that records all international transactions between a country and the rest of the world for a given period, and comprises four elements: 1) exchange arrangements/rates, 2) international payments and transfers relating to current international transactions, 3) international capital movements, and 4) international reserves.
Currency regimes (aka exchange rate regimes) determines how a nation values its currency in comparison to other nations. The exchange rate regime is how a nation manages its currency in the foreign exchange market and is closely related to the nation’s monetary policy. There are two primary exchange rate regimes: flexible (floating) exchange and the fixed exchange. In real world practice, however, exchange rate regimes run the gamut from currency boards and traditional pegs to crawling pegs, target zones, and floats with varying degrees of intervention.
Fixed Exchange Rates
Fixed exchange rates are “fixed” by the government and not determined by market forces, and only small deviations from this fixed value is possible. With fixed exchange rates, foreign central banks buy and sell their currencies at a fixed price. A fixed exchange rate is generally seen as being transparent and a simple anchor for monetary policy. An example of this system was used under the Gold Standard where each country committed itself to convert freely its currency into gold at a fixed price. The value of each foreign currency was defined in terms of gold and the exchange rate was fixed according to the gold value of currencies that had to be exchanged.
Fixed Exchange Rates: Pros & Cons
Proponents in favor of fixed exchange rates show that it ensures stability in the exchange rate that stimulates foreign trade, contributes to the coordination of macro policies of countries, and is more conducive to the expansion of world trade because it prevents risk and uncertainty in transactions involving speculation in foreign exchange markets. Some drawbacks of fixed exchange rates include the fear of devaluation, where a central bank may use its reserves to maintain the foreign exchange rate, and when reserves are exhausted that compels the government to devalue its domestic currency. Additionally, the benefits of free markets are deprived since everything is fixed and there is the possibility of under/over valuation.
Flexible Exchange Rates
Flexible exchange rates are determined by forces of demand and supply of the foreign exchange market and the value of currency can float freely in tandem with the change in demand and supply of foreign exchange. With flexible exchange rates, the nation’s central bank allows the exchange rate to be commensurate with the supply and demand of the foreign currency. Flexible exchange rates have the advantage that they allow a country to pursue an independent monetary policy, rather than have its own monetary policy set by an anchor currency country.
Flexible Exchange Rates: Pros & Cons
Proponents of floating exchange rates argue that is generally agreed and accepted that major currencies (dollar, euro and yen) float against one another. These currencies represent economies that account for nearly half of global all economic activity and virtually all global trade is denominated in one of these three currencies. Flexible exchange rates also allow a country to have its own monetary policy, free from the constraints set by another country. Flexible exchange rates are more resilient in troubled times and can distribute the burden of adjustment between the external sector and the domestic economy more seamlessly. Some drawbacks of flexible exchange rates are the creation of potentially unstable conditions where instability and uncertainty may exist. Another drawback is that flexible exchange rates can cause extreme fluctuations in imports/exports and undermine the economic stability of a nation. Flexible exchange rates also expose itself to inflationary risk due to the exchange depreciation on the nation’s price level.
In the 19th and early 20th centuries, the British Empire dominated the world and the British Pound was the primary currency that was used in international trade. During the decline of the British Empire in the middle-half of the 20th century, the U.S. dollar became the leading currency and reigned for over 50 years. On January 1, 1999, the Euro was created and originally replaced the national currency of 11 European nations.
The positive corollaries from adopting the Euro included smoother business operations, since imports and exports between Eurozone nations were no longer subjected to fluctuating exchange rates. Additionally, tourism significantly increased since members of the Eurozone would now be able to travel to multiple locations within the Eurozone without having to exchange their currencies on a frequent basis. Another less concrete but still apparent benefit was the pride among nations in being part of a larger group with one unified currency. The Euro has proven itself as a successful currency and has resulted in booming exports for powerhouse and peripheral countries and low interest rates for many years.
Some negative reactions to the Euro included that it could not accommodate both industrial powerhouses (including Germany and smaller countries such as Greece) and predicted that under a single currency, millions would lose their jobs and that nations would be stripped of their pride and independence. Also, in the Eurozone, many citizens were discontented to join as their country would be giving up a vital characteristic of their homes, as well as their economic flexibility. This is happening today with the United Kingdom scheduled to leave the European Union in early 2019, which is known as Brexit. Many countries that joined the Eurozone had low approval rates due to the loss of a national autonomy and the burden of paying higher prices for goods and services.
It is very important to understand exchange rates when working or traveling outside of the U.S. since your dollar may be worth much more or less than you think. This article provided a concise overview of the history and importance of the international monetary system. Then, currency regimes were reviewed along with providing an overview or fixed/flexible exchange rates. Finally, the creation of the Euro was evaluated along with discussing its benefits and problems.
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