CHAPTER FIVE

5. INTERNATIONAL MONETARY SYSTEM AND KEY

INTERNATIONAL FINANCIAL INSTITUTIONS
Introduction
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.
5.1 The International Monetary System
An international monetary system is a set of internationally agreed rules, conventions and
supporting institutions that facilitate international trade, cross border investment and generally
the reallocation of capital between states that have different currencies. It should provide means
of payment acceptable to buyers and sellers of different nationalities, including deferred payment.
To operate successfully, it needs to inspire confidence, to provide sufficient liquidity for
fluctuating levels of trade, and to provide means by which global imbalances can be corrected. The
system can grow organically as the collective result of numerous individual agreements between
international economic factors spread over several decades. Alternatively, it can arise from a single
architectural vision, as happened at Bretton Woods in 1944.
Historically, until the 19th century, the global monetary system was loosely linked at best, with
Europe, the Americas, India and China (among others) having largely separate economies, and
hence monetary systems were regional. European colonization of the Americas, starting with the
Spanish empire, led to the integration of American and European economies and monetary
systems, and European colonization of Asia led to the dominance of European currencies, notably
the British pound sterling in the 19th century, succeeded by the US dollar in the 20th century.
Some, such as Michael Hudson, foresee the decline of a single base for the global monetary
system, and the emergence instead of regional trade blocs; he cites the emergence of the Euro as
an example. It was in the later-half of the 19th century that a monetary system with close to
universal global participation emerged, based on the gold standard.

5.2 History of modern global monetary orders

According to J. Lawrence Broz and Jeffry A. Frieden, the sustainability of international monetary
cooperation has tended to be affected by:
1. A shared interest in currency stability
2. Interlinkages to other important issues
3. The presence of institutions that formalize the international monetary cooperation
4. The number of actors involved, in particular whether one or a few powerful states are
willing to take the lead in managing international monetary affairs
5. Macroeconomic conditions (during economic downturns, states are incentivized to defect
from international monetary cooperation)
The International Monetary System (IMS) constitutes an integrated set of money flows and related
governance institutions that establish the quantities of money, the means for supporting currency
requirements and the basis for exchange among currencies in order to meet payments obligations
within and across countries. Central banks, international financial institutions, commercial banks
and various types of money market funds — along with open markets for currency and, depending
on institutional structure, government bonds — are all part of the international monetary
system. The key distinguishing factor for the IMS is that money (in contrast to financial assets)
is not interest bearing. Money is used as a unit of account and/or a medium of exchange to support
and foster the exchange of goods and services, and capital flows, within and across countries; to
calibrate values and advance the exchange of financial assets; and to foster the development of
financial markets. Traditional definitions of money also include its role as a store of value, but
that role has been largely assumed by financial assets. Although this view may be controversial,
the store of value for money is, at a minimum, shared with the international financial system and
may be completely assumed by it.
International Financial System
The international financial system (IFS) constitutes the full range of interest‐ and return‐bearing
assets, bank and nonbank financial institutions, financial markets that trade and determine the
prices of these assets, and the nonmarket activities (e.g., private equity transactions, private
equity/hedge fund joint ventures, leverage buyouts whether bank financed or not, etc.) through
which the exchange of financial assets can take place. The IFS lies at the heart of the global credit
creation and allocation process. To be sure, the IFS depends on the effective functioning and
prudent management of the IMS and the ready availability of currencies to support the payment
system. Nevertheless, the IFS extends far beyond IMS’s common payments and currency pricing
role to encompass the full range of financial assets, including derivatives, credit classes and the
institutions that engage in the exchange of these assets as well as their regulatory and governing
bodies. The IFS encompasses the IMS — but extends in function and complexity well beyond the
IMS. Government debt links the two systems, as government debt can function as “near money”
in a zero interest rate environment. Many financial transactions pass through a stage of payment
in money (i.e., a demand deposit) — quickly — to a “riskless” interest‐bearing asset, like
government bonds. When “riskless” assets become more “risky” and less liquid, the payment
system slows down and may even be upended. Examples The sovereign debt crisis, such as the
one now under way in Europe, is primarily a crisis of the IMS. Sovereign debt lies at the heart of
a monetary system because it constitutes a source of riskless assets that balance the risk profile of
other assets held on bank balance sheets. When interbank markets become concerned about the
quality of sovereign debt, the event creates counter‐party risk that disrupts interbank borrowing,
which is a critical instrument of shared bank liquidity. As is the case in the current European crisis,
the liquidity crisis within the banking
5.3 The Evolution of the International Monetary System
Since the 19th Century, the international monetary system has gone through four stages in its
evolution: (1) the gold standard (1880–1914); (2) the gold-exchange standard (1925–1933); (3)
the Bretton Woods system (1944–1971); and (4) the Jamaica system, also known as the floating
exchange rate system (1976–present). 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

In the years from 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.

Features of the Floating (Flexible) Exchange Rate System

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.

Main Functions of the International Monetary System

The following are some of the main functions of the international monetary system:

• Facilitates the free flow of different currencies in the open market.

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

Examples: 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.

Advantages and Disadvantages of the International Monetary System

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.

5.4 Key International Financial Institutions

5.4.1 The International Monetary Fund (IMF)

The IMF is a major financial agency of the United Nations, and an international financial
institution, headquartered in Washington, D.C., consisting of 190 countries. Its stated mission is
"working to foster global monetary cooperation, secure financial stability, facilitate international
trade, promote high employment and sustainable economic growth, and reduce poverty around the
world."

The International Monetary Fund (IMF) works to achieve sustainable growth and prosperity for
all of its 190 member countries. It does so by supporting economic policies that promote financial
stability and monetary cooperation, which are essential to increase productivity, job creation, and
economic well-being. The IMF is governed by and accountable to its member countries.

Formed in 1944, started on 27 December 1945, at the Bretton Woods Conference primarily by the
ideas of Harry Dexter White and John Maynard Keynes, it came into formal existence in 1945
with 29 member countries and the goal of reconstructing the international monetary system. It now
plays a central role in the management of balance of payments difficulties and international
financial crises. Countries contribute funds to a pool through a quota system from which countries
experiencing balance of payments problems can borrow money. As of 2016, the fund
had XDR 477 billion (about US$667 billion). The IMF is regarded as the global lender of last
resort.

Through the fund and other activities such as the gathering of statistics and analysis, surveillance
of its members' economies, and the demand for particular policies, the IMF works to influence the
economies of its member countries. The organization's objectives stated in the Articles of
Agreement are: to promote international monetary co-operation, international trade, high
employment, exchange-rate stability, sustainable economic growth, and making resources
available to member countries in financial difficulty.

IMF funds come from two major sources: quotas and loans. Quotas, which are pooled funds of
member nations, generate most IMF funds. The size of a member's quota depends on its economic
and financial importance in the world. Nations with greater economic significance have larger
quotas. The quotas are increased periodically as a means of boosting the IMF's resources in the
form of special drawing rights.

What Does The IMF Do?

The IMF has three critical missions: furthering international monetary cooperation, encouraging
the expansion of trade and economic growth, and discouraging policies that would harm
prosperity. To fulfill these missions, IMF member countries work collaboratively with each other
and with other international bodies.

The IMF fosters international financial stability by policy advise, financial assistance and capacity
development.

5.4.2 The World Bank Group

The World Bank Group (WBG) is a family of five international organizations that make leveraged
loans to developing countries. It is the largest and best-known development bank in the world and
an observer at the United Nations Development Group. The bank is headquartered in Washington,
D.C. in the United States. It provided around $98.83 billion in loans and assistance to "developing"
and transition countries in the 2021 fiscal year.

The bank's stated mission is to achieve the twin goals of ending extreme poverty and building
shared prosperity. Total lending as of 2015 for the last 10 years through Development Policy
Financing was approximately $117 billion. Its five organizations are the International Bank for
Reconstruction and Development (IBRD), the International Development Association (IDA),
the International Finance Corporation (IFC), the Multilateral Investment Guarantee
Agency (MIGA) and the International Centre for Settlement of Investment Disputes (ICSID). The
first two are sometimes collectively referred to as the World Bank.

The World Bank Group is one of the world’s largest sources of funding and knowledge for
developing countries. Its five institutions share a commitment to reducing poverty, increasing
shared prosperity, and promoting sustainable development.

Together, IBRD and IDA form the World Bank, which provides financing, policy advice, and
technical assistance to governments of developing countries. IDA focuses on the world’s poorest
countries, while IBRD assists middle-income and creditworthy poorer countries.

IFC, MIGA, and ICSID focus on strengthening the private sector in developing
countries. Through these institutions, the World Bank Group provides financing, technical
assistance, political risk insurance, and settlement of disputes to private enterprises, including
financial institutions.

What Does the World Bank Group Do?

The World Bank's (the IBRD's and IDA's) activities focus on developing countries, in fields such
as human development (e.g. education, health), agriculture and rural development (e.g. irrigation
and rural services), environmental protection (e.g. pollution reduction, establishing and enforcing
regulations), infrastructure (e.g. roads, urban regeneration, and electricity), large industrial
construction projects, and governance (e.g. anti-corruption, legal institutions development). The
IBRD and IDA provide loans at preferential rates to member countries, as well as grants to the
poorest countries. Loans or grants for specific projects are often linked to wider policy changes in
the sector or the country's economy as a whole. For example, a loan to improve coastal
environmental management may be linked to the development of new environmental institutions
at national and local levels and the implementation of new regulations to limit pollution.

5.5 The Multinational Corporations

A multinational corporation (MNC) is a company that has business operations in at least one
country other than its home country. By some definitions, it also generates at least 25% of
its revenue outside of its home country.

Generally, a multinational company has offices, factories, or other facilities in different countries
around the world as well as a centralized headquarters which coordinates global management.

Multinational companies can also be known as international, stateless, or transnational corporate

organizations or enterprises. Some may have budgets that exceed those of small countries.

Characteristics of a Multinational Corporation

Some of the characteristics common to various types of multinational corporations include:

• A worldwide business presence

• Typically, large and powerful organizations
• Business conducted in various languages
• A complicated business model and structure
• Direct investments in foreign countries
• Jobs created in foreign countries, potentially with higher wages than found locally
• Seeks improved efficiencies, lower production costs, larger market share
• Has substantial expenses associated with navigating rules and regulations of foreign
countries
• Pays taxes in countries in which it operates
• Reports financial information according to International Financial Reporting
Standards (IFRS)
• Sometimes accused of negative economic and/or environmental impacts in foreign
markets
• Sometimes accused of negative economic impacts in home country due to outsourcing
jobs