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Key Issues about the International Monetary System

Part of the International Finance For Dummies Cheat Sheet

The international monetary system is a way for people to conduct business with each other from different parts of the world. The system covers types of money from different countries and the resulting exchange rates as well as the characteristics of various exchange rate regimes. The following points are good to keep in mind to understand how the international monetary system works:

  • Exchange rate regimes when money is based on a metallic standard. If money has an intrinsic value, in other words, if its value is based on a precious metal, it leads to a fixed exchange rate system. For most of history, money was based on some variation of a metallic standard. The last period with such a standard (called reserve currency standard) ended in 1971. One of the challenges of a metallic standard is that it doesn’t allow countries to conduct independent monetary policies.

  • Exchange rate regimes when money is fiat (no metallic standard). Fiat currency has no intrinsic value and doesn’t lead to a specific exchange rate regime. In this case, countries decide about their exchange rate regime. When the last metallic standard period (or a variation of it) ended in 1971, money in all countries was fiat money. However, most developed countries decided for flexible exchange rate regimes where the value of currencies is decided in foreign exchange markets with minimum interventions based on the demand for and supply of currencies.

  • Pegged regimes and their purpose in a fiat currency system. After 1971, most developing countries adopted a variety of pegged exchange rate regimes. One of the important factors that affect the type of the pegged regime is the extent to which the pegged regime can exercise control over monetary policy. Hard pegs such as currency board and dollarization don’t allow monetary policy to be used as much as soft pegs do. While hard pegs are used to signal stability, soft pegs can serve to make exports or imports cheaper or to attract foreign investors.

  • Optimum currency area and the Euro. The concept of the optimum currency area shows that under certain circumstances it would be more efficient to have a common currency in a region, consisting of countries with their own currencies. The term optimum implies the requirements for an efficiency-enhancing common currency. Countries in the common-currency region should experience similar economic shocks and have labor mobility among them. Despite benefits, a common currency requires a strong monetary policy coordination as well as fiscal policy coordination.

  • Tradeoffs associated with various exchange rate regimes. All exchange rate regimes have their costs and benefits, which implies tradeoffs. The table provides a summary of the costs and benefits associated with various exchange rate regimes.

    Exchange Rate Regimes Pro Con
    Fixed
    (commodity money)
    No sudden changes in ER
    No need to forecast future exchange rates
    Importing other countries’ domestic economic problems, such as inflation and unemployment
    Monetary policy cannot be used as stabilization policy
    Flexible
    (fiat money)
    Insulation of countries from other countries’ economic problems, such as inflation and unemployment
    Ability to conduct monetary policy
    Excessive volatility in exchange rates
    Pegged
    (fiat money)
    Stability provided by a nominal anchor
    Aiding economic development through adjusting the price of exports or imports as well as attracting portfolio flows
    Efficiency cost of keeping prices of exports or imports low
    Prone to speculative attack; hot money leaving the country fast if investors doubt the credibility of the peg
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