International Monetary Fund: Manager of Fixed Exchange Rates - dummies

International Monetary Fund: Manager of Fixed Exchange Rates

By Ayse Evrensel

The International Monetary Fund (IMF)’s Articles of Agreement implied both discipline and flexibility, to avoid the mistakes of the interwar period. The discipline part of the agreement implied that the value of the dollar was to be pegged to gold and that all other currencies were to be pegged to the dollar, which led to fixed exchange rates.

The flexibility part ensured that countries having trouble with keeping the fixed exchange rate would receive financial assistance. This was supposed to work as a remedy to the mistakes during the interwar period, when countries tried to maintain fixed exchange rates at the expense of free trade and employment.

Because unilateralism caused so many problems during the interwar years, the IMF, as a multilateral institution, had to offer facilities to assist countries with external balance problems. The lending facilities of the IMF aimed to reduce member countries’ current account problems by providing additional liquidity.

However, if the IMF were to provide liquidity to member countries, the organization needed funds. Therefore, a subscription system was created in which IMF members were assigned quotas that reflected the countries’ relative economic power. This subscription was to be paid 25 percent in either gold or the reserve currency (dollar) and 75 percent in the member’s own currency. The quota system helped the IMF establish a pool of gold and currencies.

Now with funds at its disposal, the IMF was charged with managing current account deficits to avoid large currency devaluations. To make substantial changes in the exchange rate, a member country needed the IMF’s determination and approval that the country was suffering from a fundamental disequilibrium.

However, no explicit definition was drafted for what constitutes a fundamental equilibrium. Clearly, what constitutes a fundamental disequilibrium would change from country to country as well as over time.

Even though international trade was a major headache in maintaining the external balance, the IMF promoted free international trade and urged its members to make their currencies convertible. Convertibility in currencies, also called current account convertibility, means that all currencies can be acquired and exchanged with other currencies.

Clearly, if a country’s currency isn’t traded, it discourages trade with that country. U.S. and Canadian dollars became convertible as early as 1945. Most European countries restored convertibility in 1958, and Japan joined later, in 1964.

In addition to current account convertibility, capital account convertibility implies the free flow of capital between countries. Capital account convertibility is part of the trilemma in international finance. Maintaining internal balance (full employment level of output) and external balance (fixed exchange rate) while capital freely moves between countries is called the trilemma because you cannot achieve these three goals simultaneously.

Therefore, the IMF allowed restrictions on capital flows, which gave countries more freedom to use monetary policy to address internal imbalances. Based on the experience during the interwar years, in an attempt to attract investors in their countries, countries with current account deficits implemented contractionary monetary policies to keep their interest rates higher.

This particular policy decision led to lower output, higher unemployment, and deflation in a deficit country. Additionally, as other countries felt compelled to do the same, severe recessions simultaneously happened in many countries. To avoid such an outcome, the IMF allowed restrictions to be placed on capital flows so that countries could use their monetary policy to address domestic macroeconomic problems.