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The International Monetary System
◼ Learning Objectives
1. Explore how the international monetary system has evolved from the days of the gold
standard to today’s eclectic currency arrangement
2. Examine how the choice of fixed versus flexible exchange rate regimes is made by a
country in the context of its desires for economic and social independence and openness
3. Describe the tradeoff a nation must make between a fixed exchange rate, monetary
independence, and freedom of capital movements—the impossible trinity
4. Explain the dramatic choices the creation of a single currency for Europe—the euro—
required of the European Union’s member states
5. Study the complexity of exchange rate regime choices faced by many emerging market
countries today including China
◼ Chapter Outline
I. History of the International Monetary System
A. The Gold Standard, 1876–1913
B. The Interwar Years and World War II, 1914–1944
C. Bretton Woods and the International Monetary Fund, 1944
D. Fixed Exchange Rates, 1945–1973
E. The Floating Exchange Rates, 1973–1997
F. The Emerging Era, 1997–Present
G. IMF Classification of the Currency Regimes
H. Brief Classification History
I. The IMF’s 2009 de facto System
Category 1: Hard Pegs
Category 2: Soft Pegs
Category 3: Floating Arrangements
Category 4: Residual
J. A Global Eclectic
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II. Fixed Versus Flexible Exchange Rates
III. The Impossible Trinity
A. Exchange Rate Stability
B. Full Financial Integration
C. Monetary Independence
IV. A Single Currency for Europe: The Euro
A. The Maastricht Treaty and the Monetary Union
B. The European Central Bank (ECB)
C. The Launch of the Euro
V. Emerging Markets and Regime Choices
A. Currency Boards
C. Currency Regime Choices for Emerging Markets
D. Globalizing the Chinese Renminbi
E. Two-Market Currency Development
F. Theoretical Principles and Practical Concerns
The Triffin Dilemma
G. Exchange Rate Regimes: What Lies Ahead?
1. The Rules of the Game. Under the gold standard, all national governments promised to
follow the “rules of the game.” What did this mean?
A country’s money supply was limited to the amount of gold held by its central bank or
treasury. For example, if a country had 1,000,000 ounces of gold and its fixed rate of
exchange was 100 local currency units per ounce of gold, that country could have
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100,000,000 local currency units outstanding. Any change in its holdings of gold needed to
be matched by a change in the number of local currency units outstanding.
2. Defending a Fixed Exchange Rate. What did it mean under the gold standard to “defend a
fixed exchange rate,” and what did this imply about a country’s money supply?
Under the gold standard, a country’s central bank was responsible for preserving the
exchange value of the country’s currency by being willing and able to exchange its
currency for gold reserves upon the demand of a foreign central bank. This required the
country to restrict the rate of growth in its money supply to a rate that would prevent
inflationary forces from undermining the country’s own currency value.
3. Bretton Woods. What was the foundation of the Bretton Woods international monetary
system, and why did it eventually fail?
Bretton Woods, the fixed exchange rate regime of 1945–73, failed because of widely
diverging national monetary and fiscal policies, differential rates of inflation, and various
unexpected external shocks. The U.S. dollar was the main reserve currency held by central
banks and was the key to the web of exchange rate values. The United States ran persistent
and growing deficits in its balance of payments requiring a heavy outflow of dollars to
finance the deficits. Eventually the heavy overhang of dollars held by foreigners forced the
United States to devalue the dollar because the United States was no longer able to
guarantee conversion of dollars into its diminishing store of gold.
4. Technical Float. Speaking very specifically—technically, what does a floating rate of
exchange mean? What is the role of government?
A truly floating currency value means that the government does not set the currency’s
value or intervene in the marketplace, allowing the supply and demand of the market for
its currency to determine the exchange value.
5. Fixed versus Flexible. What are the advantages and disadvantages of fixed exchange
• Fixed rates provide stability in international prices for the conduct of trade. Stable
prices aid in the growth of international trade and lessen risks for all businesses.
• Fixed exchange rates are inherently anti-inflationary, requiring the country to follow
restrictive monetary and fiscal policies. This restrictiveness, however, can often be a
burden to a country wishing to pursue policies that alleviate continuing internal
economic problems, such as high unemployment or slow economic growth.
• Fixed exchange rate regimes necessitate that central banks maintain large quantities of
international reserves (hard currencies and gold) for use in the occasional defense of
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the fixed rate. As international currency markets have grown rapidly in size and
volume, increasing reserve holdings has become a significant burden to many nations.
• Fixed rates, once in place, may be maintained at rates that are inconsistent with
economic fundamentals. As the structure of a nation’s economy changes, and as its
trade relationships and balances evolve, the exchange rate itself should change. Flexible
exchange rates allow this to happen gradually and efficiently, but fixed rates must be
changed administratively—usually too late, too highly publicized, and at too large a
one-time cost to the nation’s economic health.
6. De facto and de jure. What do the terms de facto and de jure mean in reference to the
International Monetary Fund’s use of the terms?
A country’s actual exchange rate practices is the de facto system. This may or may not
match the “official” or publicly and officially system commitment, the de jure system.
7. Crawling Peg. How does a crawling peg fundamentally differ from a pegged exchange
In a crawling peg system, the government will make occasional small adjustments in its
fixed rate of exchange in response to changes in a variety of quantitative indicators such as
inflation rates or economic growth. In a truly pegged exchange rate regime, no such changes
or adjustments are made to the official fixed rate of exchange.
8. Global Eclectic. What does it mean to say the international monetary system today is a
The current global market in currency is dominated by two major currencies, the U.S.
dollar and the European euro, and after that, a multitude of systems, arrangements,
currency areas, and zones.
9. The Impossible Trinity. Explain what is meant by the term Impossible Trinity, and why it
is in fact “impossible.”
• Countries with floating rate regimes can maintain monetary independence and
financial integration but must sacrifice exchange rate stability.
• Countries with tight control over capital inflows and outflows can retain their
monetary independence and stable exchange rate, but surrender being integrated with
the world’s capital markets.
• Countries that maintain exchange rate stability by having fixed rates give up the ability
to have an independent monetary policy.
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10. The Euro. Why is the formation and use of the euro considered to be such a great
accomplishment? Was it really needed? Has it been successful?
The creation of the euro required a near-Herculean effort to merge the monetary
institutions of separate sovereign states. This required highly disparate cultures and
countries to agree to combine, giving up a large part of what defines an independent state.
Member states were so highly integrated in terms of trade and commerce, maintaining
separate currencies and monetary policies was an increasing burden on both business and
consumers, adding cost and complexity that added sizeable burdens to global
competitiveness. The euro is widely considered to have been extremely successful since its
11. Currency Board or Dollarization. Fixed exchange rate regimes are sometimes
implemented through a currency board (Hong Kong) or dollarization (Ecuador). What is
the difference between the two approaches?
In a currency board arrangement, the country issues its own currency but that currency is
backed 100% by foreign exchange holdings of a hard foreign currency—usually the U.S.
dollar. In dollarization, the country abolishes its own currency and uses a foreign currency,
such as the U.S. dollar, for all domestic transactions.
12. Argentine Currency Board. How did the Argentine currency board function from 1991 to
January 2002 and why did it collapse?
Argentina’s currency board exchange regime of fixing the value of its peso on a one-to-one
basis with the U.S. dollar ended for several reasons:
• As the U.S. dollar strengthened against other major world currencies, including the
euro, during the 1990s, Argentine export prices rose vis-à-vis the currencies of its major
• This problem was aggravated by the devaluation of the Brazilian real in the late 1990s.
• These two problems, in turn, led to continued trade deficits and a loss of foreign
exchange reserves by the Argentine central bank. (4) This problem, in turn, led
Argentine residents to flee from the peso and into the dollar, further worsening
Argentina’s ability to maintain its one-to-one peg.
13. Special Drawing Rights. What are Special Drawing Rights?
The Special Drawing Right (SDR) is an international reserve asset created by the IMF to
supplement existing foreign exchange reserves. It serves as a unit of account for the IMF
and other international and regional organizations and is also the base against which some
countries peg the exchange rate for their currencies.
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Defined initially in terms of a fixed quantity of gold, the SDR has been redefined
several times. It is currently the weighted value of currencies of the five IMF members
having the largest exports of goods and services. Individual countries hold SDRs in the
form of deposits in the IMF. These holdings are part of each country’s international
monetary reserves, along with official holdings of gold, foreign exchange, and its reserve
position at the IMF. Members may settle transactions among themselves by transferring
14. The Ideal Currency. What are the attributes of the ideal currency?
If the ideal currency existed in today’s world, it would possess three attributes, often
referred to as The Impossible Trinity:
15. Exchange rate stability. The value of the currency would be fixed in relationship to other
major currencies so traders and investors could be relatively certain of the foreign
exchange value of each currency in the present and into the near future.
16. Full financial integration. Complete freedom of monetary flows would be allowed, so
traders and investors could willingly and easily move funds from one country and
currency to another in response to perceived economic opportunities or risks.
17. Monetary independence. Domestic monetary and interest rate policies would be set by
each individual country to pursue desired national economic policies, especially as they
might relate to limiting inflation, combating recessions, and fostering prosperity and full
The reason that it is termed The Impossible Trinity is that a country must give up one of
the three goals described by the sides of the triangle, monetary independence, exchange
rate stability, or full financial integration. The forces of economics do not allow the
simultaneous achievement of all three.
18. Emerging Market Regimes. High capital mobility is forcing emerging market nations to
choose between free-floating regimes and currency board or dollarization regimes. What
are the main outcomes of each of these regimes from the perspective of emerging market
Highly restrictive regimes like currency boards and dollarization require a country to give
up the majority of its discretionary ability over its own currency’s value. Currency boards,
like that used by Argentina in the 1990s, restricted the rate of growth in the country’s
monetary policy in order to preserve a fixed exchange rate regime. This proved to be a
very high price for Argentine society to pay, and in the end, it could not be maintained.
Dollarization, an even more radical extreme in the adoption of another country’s currency
for all exchange, removes one of a government’s major attributes of sovereignty.
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A free-floating rate of exchange is, however, in many ways not that different from the
highly restrictive choices just mentioned. In a free-floating regime, the government allows
the foreign currency markets to determine the currency’s value, although the government
does maintain sovereignty over its own monetary policy, which in turn has significant
direct impacts on the currency’s value.
19. Globalizing the Yuan. What are the major changes and developments that must occur for
the Chinese yuan to be considered “globalized?”
First, the yuan must become readily accessible for trade transaction purposes. This is the
fundamental and historical use of currency. Secondly, it then needs to mature toward a
currency easily and openly usable for international investment purposes. The third and
final stage of currency globalization is when the currency itself takes on a role as a reserve
currency, currency held by central banks of other countries as a store of value and a
medium of exchange for their own currencies.
20. Triffin Dilemma. What is the Triffin Dilemma? How does it apply to the development of
the Chinese yuan as a true global currency?
The Triffin Dilemma is the potential conflict in objectives that may arise between domestic
monetary and currency policy objectives and external or international policy objectives
when a country’s currency is used as a reserve currency. Domestic monetary and economic
policies may on occasion require both contraction and the creation of a current account
surplus (balance on trade surplus).
21. China and the Impossible Trinity. What choices do you believe that China will make in
terms of the Impossible Trinity as it continues to develop global trading and use of the
This is purely speculative opinion, but many believe China will continue to move the yuan
toward globalization rapidly. As Chinese financial institutions and policies become more
mature, and policies more consistent with those of other major country financial markets,
the yuan will grow as a medium of exchange for both commercial trade and capital
investment transactions. The gradual opening of the Chinese economy to foreign
investment is a critical component of this process.