International Monetary System

The international monetary system is a set of conventions and rules that support cross-border investments, trades, and the reallocation of capital between different countries. These rules define how exchange rates, macroeconomic management, and balance of payments are addressed between nations. The international monetary system structure was reformed after the North Atlantic financial crisis of 2008-2009.

The International Monetary System comprises central and commercial banks, international financial institutions, and various money market funds, including open market funds from the currency and bond markets. In their eyes, money is a medium of exchange that facilitates the exchange of capital flows, goods, and services across countries.

• International Monetary System refers to the framework in the world of foreign exchange through which capital movements and trade of goods and services are facilitated.
• It has evolved from using gold as a means of exchange in the 1880s to implementing the floating exchange rates since the convention in Jamaica in 1971.
• Its systems ensure sufficient liquidity to aid the temporary Balance of Payments (BOP) deficits.
• It also allows member countries to practice independent fiscal and monetary policies according to the state of their respective economies.

The international monetary system is the operating system of the global financial environment. This body comprises investors, multinational companies, and financial institutions. The International Monetary System formulates the framework that facilitates the exchange rates, international payments, and movement of capital between two countries with different currencies.

The prerogative of the International Monetary System is to facilitate the exchange of capital, goods, and services between countries. The International Monetary Fund (IMF) oversees articles of the agreement signed in this regard between countries. The responsibility of member countries is to formulate economic and financial policies that facilitate the economic and financial conditions to ultimately result in economic growth by maintaining price stability.

Moreover, member countries take active action toward creating systems that help avoid manipulation or tampering of exchange rates and keep improving rate change policies that foster growth and safety to benefit the global economy. To broaden the approach from just focusing on exchange rates, the IMF sought to create external stability through a balance of payments system that eliminates uncontrollable exchange rate movements.

Since IMF is a multilateral institution, its policies and regulations help the functioning of the International Monetary System. More so, as IMF plans to extend its reach and address issues such as inequalities, financial supervision, poverty, and climate change. However, it is essential to note that The International Monetary Fund (IMF) has no power or control over the International Monetary System. Beyond domestic policies and other primary policies relating to the financial sector.

Since the formulation of the Financial Sector Assessment Program (FSAP) and its mandatory application to 25 countries in 2009, IMF has been the central source of surveillance, supervision, and policy-generating body that stands to erode its stability.

Since the 19^th Century, the International Monetary System has undergone four stages of evolution at different points in time to form the structure as we know it today. Let us understand the occurrences that led to the changes and their current implications through the points below:

#1 - The Gold Standard

Between 1880 and 1914, the gold standard was referred to as the monetary system through which each country could fix the value of their currency in terms of gold. The exchange rate was based on the determined value. For example, if the U.S. fixed 1 ounce of gold = $20. The United Kingdom had set the value of one ounce of gold equal to 10 pounds. Then, the pound-dollar exchange rate would be $20 = 10 Pounds.

The gold standard system had a fixed exchange rate system that facilitated the free convertibility of gold into national currencies and vice versa. The most significant advantage of this system was its ability to correct imbalances. As gold payments make balancing off easier, settling the balance of payment (BOP) deficits or surpluses could be easy. Moreover, the fixed exchange rates made international trade easier under the gold standard.

#2 - The War Period

Between 1925-1933 between the world wars, the gold standard started losing its way. The war had created a dent in the world economy, and every country wanted to export more to revamp and rebuild their economies.

Therefore, they significantly depreciated their currencies' value to export extensively and benefit from economies of scale. This period of chaos and rebuilding saw exchange rates fluctuate and competitive devaluation unlike ever before.

#3 - The Bretton Woods System

Only a few nations had the resources to survive after two world wars, while others struggled to feed their citizens. In times like these, the United States of America and the United Kingdom started discussing the possibilities and ways to rebuild the world economy after two disastrous wars in the mid-1940s.

The United Nations formulated the new international monetary system at the Bretton Woods Conference in Bretton Woods, New Hampshire. The Bretton-woods conference led to the creation of a dollar-based fixed exchange rate system. Under this system, the U.S. dollar was backed by reserve gold. All other currencies did not have to maintain a gold reserve for conversion. Therefore, the conversion rates were minimal.

#4 - The Jamaica System

Around 1971, high inflation rates and a trade deficit led to a gold process hike. Therefore, the U.S. had to stop the convertibility of gold. Owing to factors like these, the Bretton woods system collapsed.

Hence the global economy moved towards a flexible exchange rate system in 1973 and by 1976. They formalized the system through the convention in Jamaica. Under the Jamaica or floating rate system, demand and supply would affect the currency exchange rates.

Let us discuss the key features of the Floating rate system through the points below:

#1 - Independence

The push and pull of the market enforce the exchange rate. Hence, there is no need for government intervention, which makes it far more transparent than its alternatives.

#2 - Constant Fluctuation

A feature of the reiteration of the 'floating' exchange system is the constant fluctuation of rates due to the movements in the market.

#3 - Adjustments

The balance of payments (BOP) is adjusted with exchange rates. The surplus or deficit of funds between countries is settled through the real-time rates displayed on the exchange.

#4 - Transparency

Interventions do not bind the smooth conduct of exchange between countries from the full reigns of governments or central banks. Thereby, the fluctuation of exchange rates is backed by market factors beyond the control of any individual or centralized organization.

Let us discuss the functions of the International Monetary System through the points below:

• Facilitates the free flow of different currencies in the open market.
• Restrict intervention from government or central banks only in cases of currency stabilization.
• Third, facilitate global trade of goods, services, and money.
• Fourth, Maintain a system that regulates the exchange rates through the forces of the market and not by any particular institution or organization.

Let us understand the concept better through the examples below:

Example #1

Country A borrows $100 million from Country B to finance its infrastructural development for a repayment schedule of 10% each year with interest. Due to the exchange rate fluctuations, country A benefits from the dip in USD in the first year but pays extra the following year. However, member countries can maintain repayment schedules irrespective of the movement through BOP calculations.

Example #2

For close to a century, the world’s economies have been using U.S. dollars as their reserve currency as it is globally viable and is the strongest currency in the market. However, since 2022, Russia and China have been using the Chinese Yuan as a means of payment for Russian oil. Other countries, such as Saudi Arabia, have also considered doing the same.

China has been on a gold purchasing spree to shift the global reserve currency towards the Chinese Yuan. However, due to the open nature of commodity and currency markets, only the market’s push and pull shall have a say on the future reserve currency.

Let us discuss the advantages and disadvantages of the International Monetary System through the points below:

Advantages

#1 - Liquidity

Member countries are not limited to using one anchor currency. Therefore, countries can hold surplus or reserve cash in different currencies, resulting in a more significant liquidity factor than other systems.

#2 - Larger Gains

Easing trade restrictions allows for the free exchange of currencies, benefiting governments and central banks and allowing retail investors to experience greater gains through their trades.

#3 - Confidence

International systems in the past have come under the scanner for being manipulative and deceiving. However, the International Monetary System is independent in terms of policymaking. The policies leave the exchange rates to the market's forces, leaving almost no room for manipulation.

Disadvantages

#1 - Instability

Constant fluctuations make these exchange rates unstable and sometimes unreliable in making investments or committing to trade goods and services.

#2 - Curbs International Trade

The very nature of uncertainty in the exchange rate is sometimes a hindrance. Due to the uncertainty in movement, the parties involved are inhibited from trading or investing internationally.

#3 - Elasticity

The constant rate changes cause instability, and the smaller trades get adversely affected as the price shift results in the parties taking a step back and awaiting some stability in the market.

This article has been a guide to what is International Monetary System. We explain its evolution, features, functions, examples, advantages & disadvantages. You may also find some useful articles here -

• Monetary Transmission Mechanism
• Accommodative Monetary Policy
• Financial System